“Cut your losses short and let your profits run” is something we often hear in the trading world and is basically Trading Education 101. Though the advice is sage, countless investors continue to do the opposite. That is, selling after a marginal gain only to watch as it grows higher or holding onto a stock with minimal loss only to watch it lose even more.
There is not a single person out there who will buy stocks believing it will go down in value and then will be worth less than what they had invested in. Nevertheless, it is inherent to investing when we buy stocks that drop in value. The goal, therefore, is not to completely avoid losses; rather, it is to ensure that the losses are minimal. What separates the successful investors from the rest is anticipating a capital loss before it gets out of control.
Despite the simple logic of cutting any losses short, there are still so many small investors who are left high and dry. Inevitably they are left with several stock positions with countless underlying capital losses.
At their worst, these stocks drop even lower in value and fail to recover; at the very best, it’s “dead” money. Interestingly enough, most investors believe the reason behind their unrealized losses is due to the wrong timing of buying stocks. Believing it to be a matter of bad luck is another reason. Seldomly does anyone believe that the fault lies primarily in their own behavioral biases.
A cursory glance of any major stock index’s long-term chart will show the line moving from the lower-left corner towards the upper right-hand side. It is no surprise that new highs are made over a long-term period by the stock market. This is to be expected. This is normal. The mistake is when investors assume that stocks will bounce back just because of the chance that the stock market will go higher.
The stock index is made up of companies that are successful. At one time or another, there may have been less successful stocks in the index, but it is likely that they have been dropped and replaced by other companies if their values dip significantly low.
Indexes are constantly being refreshed, with the losers replaced easily by companies who are winning the stock game. Simply put, using and relying on major indexes tends to over-exaggerate the average stock’s resiliency, which unfortunately does not always bounce back. The truth is, many companies are unable to regain their past highs; some sadly even go bankrupt.
When it comes to stocks, the general Trading Education and advice, especially for the more volatile stocks we own, is to always have a stop-loss order in place. The stop-loss order is a preventive measure that keeps emotions from taking control; more importantly, it helps limit any losses. Notably, when a stop-loss order is in place, we never adjust it every time the stock values move lower. The general consensus is to adjust only when shares are going up.
Any logical investor will take corrective measures before any of the losses worsen. There is no such thing as avoiding losses when investing. Minimizing any loss rather than all-out avoiding them is what sets successful investors apart from the rest.